When It Pays to Think Like a Finance Manager

If you want approval for a new project — purchasing new equipment or computer systems, applying for a patent, building a new store — chances are you need your company’s finance department on board. To get the green light, it helps to understand how finance people think.

Most finance managers in both large and small businesses encounter numerous proposals for capital investments and many of the people proposing these investments don’t have a clear picture of what the return will be. They’re essentially asking the company to take the cash it has generated through its business operations and spend it on something with an uncertain future return.

But finance people like me are skeptical even when the proposals do project a return. Here’s why.

Everyone always wants new equipment — new computers or other hot technologies. Do you think they’re going to do a net present value (NPV) analysis that shows they don’t need that computer? Of course not. They figure out how much the new computer system and software will cost and they compare that with the cash flow generated through efficiencies (assuming they know how to analyze returns based on cash flow). If the numbers show a negative NPV, meaning that the proposed investment isn’t justified, they change the assumptions until the NPV turns up positive.

From our point of view, in other words, most people use ROI analysis as a way to justify something they really want to do anyway. If you understand this, you will understand why experienced finance people are skeptical about proposals submitted by others. After all, you have to prepare an analysis that can stand up to their scrutiny.

Here’s a real example that happened in my business. In addition to my work as a financial trainer, I am part owner of a small manufacturing engineering company with a lot of technical employees. The two founding partners were both engineers who loved technology.

Several years ago, when I was serving as the company’s CFO, one of founders came to me and said, “Joe, I would like to buy a new three-dimensional printer.” A three-dimensional printer at that time was a big investment. He explained that when they do CAD drawings, they design the part on a flat screen and send it out to be fabricated, but often the part comes back and doesn’t fit. Then they have to scrap the part, go through a redrawing process, and have new parts fabricated. With this new technology they could take a CAD design, send it to the three-dimensional printer, and get a plastic model of the part. They could make sure it fits before they cut a more expensive metal version, thus eliminating the cost of rework.

He then said to me, “So can you do an ROI analysis? Compare the cost of the printer with the amount of cash we are going to get back over the next three to five years based on the fact that we no longer have to scrap parts?”

I asked him, “How much is a printer?” He told me that the kind he wanted would be at least $100,000.

“That’s a lot of money,” I said. “Let me ask you this question. Let’s say we figure out how much money we spend every year on rework, redrawing, and all the costs associated with that over five years. Suppose it turns out that it’s cheaper to scrap parts occasionally and spend those extra hours redesigning them than it is to buy the new printer?”

What do you think he said? Of course he said, “Well, if that’s your conclusion, then I know your analysis is wrong, because I know we need the printer.”

I replied, “So what you really want me to do is come up with a cost-justification model so that you feel good about yourself through the analysis.”

Guess what? We bought the printer. I could also tell you the story of a company owner who wanted to buy an airplane. When the CFO analyzed it and said “No way,” the owner got another CFO.

This happens more frequently than we would like to admit with capital budgeting analysis and the tools of ROI. Even large companies make investments such as acquisitions based on irrational projections. The CEO negotiates with a company he or she wants to acquire. If the numbers don’t work, the CFO is told to revise the projections so that they do.

An example was eBay’s purchase of Skype for up to $4.1 billion with incentives several years ago. (The actual price turned out to be $3.1 billion.) Most of the purchase price was for what accountants call goodwill, which essentially meant (in this case) a projection of future returns. When a company spends about $3 billion on projected returns, its shareholders have a right to expect that return to be at least $300 million every year in cash. In principle, eBay looked at its database of customers, estimated how much extra they had to spend on Skype’s services, and determined what percentage of customers would have to sign up for Skype to generate that much cash.

About 18 months after the deal closed, however, the company analyzed its returns from the acquisition and compared them with projections. The result was devastating: eBay had to take a $1.4 billion write-down as an expense against its revenue because the projections were not realistic. So the $3.1 billion asset known as Skype was now worth $1.7 billion. Not long after, the board fired the CEO.

You need to understand situations like these as you make your ROI case to your financial manager, because finance people tend to think alike. Their priorities are to generate as much cash as possible and not to waste any of it. If you want to use some of that cash for an investment, you better have a good story, and you better be able to justify your returns as concretely as possible.

We know that capital budgeting is all about estimates and assumptions, but you need to provide (and defend) numbers that are as solid as they can possibly be.